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Monday, January 25, 2010

Top Ten Signs of a Dysfunctional Board

More than ten years ago I wrote an article bearing the above title.  The article has resonated with the boards of many of my clients, as well as association executives.  It seems to me there are still plenty of barely functional boards around, so I am republishing the article again at this time.  This time, however, I will add a few comments from a legal perspective where applicable.

I hope this article will help board members and association professionals learn to identify the underlying causes of dysfunction, and to avoid and/or minimize the negative behaviors that cause it.

ATTORNEYS AND CONSULTANTS who work with associations see their share of troubled boards of directors.  In fact, I believe troubled boards outnumber focused, efficient boards by a substantial margin.  Notwithstanding their problems, most boards seem to get by, but they could be better.

This article will point out some key indicators of a dysfunctional board.  While every association has a different way of working, the presence of more than a few of these signs is cause for concern.  Key indicators include:

Focus of Negative Attention on the Executive - when one or a minority of directors is openly critical of an executive, a great deal of resources tend to be devoted to that issue.  Distrust and struggles are likely to occur,along with frequently unfounded accusations against the executive.  Many times, if not most, the problem is with the board itself, not just the executive.

This behavior highlights the corporate rule of limited authority, which provides that directors (and all others, for that matter) have only the authority that is specifically delegated to them by law, bylaws or other corporate documents.  Here, a director’s opinions of the executive are irrelevant except to the extent expressed during a board meeting.  What matters is what the board thinks, not what one or two directors might think.  Further, directors acting on their dissatisfaction of an executive without board authorization is an interference with the board’s authority.

Overly Powerful Executive - sometimes executives amass so much “control” over the association that board members feel no need to do their job, or are reluctant or too intimidated to openly question what is happening.

It is lawful for a board to delegate substantial powers to its executive, however the ultimate responsibility for the organization remains with the Board, and fiduciary duties of each director remain in place.  Here, the fiduciary duty of care and the duty of inquiry require that directors be free to ask questions and challenge any organizational decision or action.

Last Minute Proposals - if important or controversial items of business are handled via last-minute (read: sneaky) proposals when there is no true emergency, the board is probably being manipulated.  Likewise, a board that is swayed by last minute proposals, and shallow or slick presentations without full analysis and discussion, is not doing its job.

Fiduciary duties of directors require they serve with the care of an ordinary prudent person.  A prudent director would want to carefully review, consider and discuss a proposal prior to acting on it, and should refuse to act on a last minute proposal, except in the case of a genuine emergency.

Power Struggles - power struggles shift the board’s focus from the business of the board to individuals or sub-groups gaining/maintaining “control.”  A board that is controlled by an individual or sub-group is inherently dysfunctional. So, whether right or wrong about the issues, controlling the board is harmful, while use of vision, influence, knowledge and ideas is completely appropriate and desirable.

Power struggles are not necessary illegal.  Instead, they highlight the probability that the group has strayed from its governing principles.  These principles are most likely grounded in the democratic process, rather than who can amass the most power.

Vote-Counting Prior to Meeting - counting and collecting vote commitments prior to a meeting is always inappropriate.  It generally results in conflict, distrust and weak decisions because decisions are made prior to full discussion and analysis.

Vote counting prior to a meeting is not illegal, but it presupposes a willingness to commit to a position without having heard the full discussion in the boardroom, an apparent violation of the statutory fiduciary duty of care.

Lack of Civility and Respect - a board that tolerates hostility, aggressiveness, or disrespect among board members, weakens itself and wastes time and leadership input.  A weak board finds it difficult to stop abuse, personal agendas and other disruptive acts.  It may have difficulty recruiting quality members.

Neither civility nor respect is legally mandated, but it's absence clearly weakens a board.

Board Micro-management - whether you are micro-managed or not, you already know what I mean.

Board micro-management may well violate an employment contract or existing policies, but it does not violate law.  A board is free to micro-manage its executive to the extent that it can afford to waste the time and resources of the organization.

Preoccupation with Bylaws and Parliamentary Procedure - while bylaws must be adhered to, and on occasion may require clarification or interpretation, disputes about bylaws or parliamentary procedures usually indicates more serious problems beneath the surface.  See “Power Struggles” above.

See comment at Power Struggles above.

Directors as “Representatives” - when directors act as representatives of their constituents rather than in the best interests of the whole, difficulties will abound.  Some directors go so far as to criticize the decisions of the board to their constituents -- a particularly disloyal and disruptive act.

Directors owe fiduciary duties of care, inquiry and loyalty (sometimes called duty of obedience) to the corporation, first and foremost.  While directors should be keenly aware of, and even biased in favor of local/regional points of view, the director must act in the best interests of the organization as a whole.  Thus, if a director knows that a certain action is of great importance to a certain region, but that the interests of the group as a whole require a different action, the fiduciary duty of loyalty requires the director to support that different action.

Rump Sessions - while discussing problems and ideas outside of a meeting is fine, unofficial group discussions outside of official meetings nearly always exclude at least some key stakeholders, and therefore undermine communication and trust.

Notice of all directors meetings must be given to all directors.  Meetings to which only some directors receive notice is not a meeting, and persons present at that so-called meeting can take no actions.  More importantly, when corporate business is discussed among subgroups of the board, other directors are excluded, and distrust is cultivated.  This does not mean that directors should not communicate with each other about important issues.  It merely means directors should be careful about such meetings in order to avoid cultivating distrust.

These are the basic signs that I have observed in my practice.  Are there others you could share?  Please let me know.  Next broadcast, I will present some ideas and methods for improving the functionality of boards.

Monday, January 11, 2010

Is An Executive Employment Contract Really Necessary?

A long time friend and client recently asked me whether a contract between a nonprofit executive and the nonprofit was really necessary. My friend correctly noted the contract would be difficult if not impossible for the nonprofit to enforce with an employee who is determined to leave. I have known other nonprofit leaders who seem to believe an employment contract is of little or no benefit to the nonprofit, and exists only to benefit the executive. The following are some of my thoughts on this subject.

An Employment Contract is Strongly Recommended

I strongly recommend a written employment contract between nonprofits and their executive. The contract benefits both the executive and the nonprofit in many ways. Although my client is most often the nonprofit itself and not the executive, the existence of a well-crafted contract is so beneficial that the disadvantages are far outweighed by the advantages.

An executive employment contract should, among other things, clarify the role and authority of the executive, describe in detail how the relationship may be terminated and each party’s obligations at the time of termination. This eliminates unnecessary battles over the power and authority of the executive, as well as costly and disruptive disputes that frequently occur when the employer-employee relationship ends. A well-written contract will almost always completely prevent these problems.

Executive Employment Is NOT The Same As Regular Staff Employment

One of the reasons a nonprofit executive is likely to want a written employment agreement is the executive is, by necessity, not entitled to some of the job security protections afforded an ordinary employee. That is, the board of directors must be able to let an executive go for any reason it deems necessary in the best interests of the corporation. If it does not like the direction of leadership, it needs to be able to -- and arguably has a duty to -- change that direction as soon as it can practicably do so. The same is not true with an ordinary employee. In theory, the lower level the employee, the greater need for the employer to have documented business reason or "cause" for terminating the employee.

Employment Contracts Serve The Nonprofit In Many Important Ways

The reason an executive would want a written contract, as noted above, is exactly the same reason the nonprofit should want one. Specifically, the contract should set forth the terms under which the nonprofit may terminate the executive with dramatically reduced risks of lawsuits. Further, the contract should spell out exactly how the termination decision should be made, thereby lessening the risk that the executive is terminated in a hasty or unlawful manner. In effect, the contract protects the nonprofit from substantial risks.

As we all know, nonprofit executives generally work in constantly changing environments. Members of the board of directors (hereinafter, “directors”) constantly turn over, so the board itself is constantly changing. These changes can result in an unstable situation for both the nonprofit and the executive, as the change of even one or two directors can dramatically change the relationship between the board and the executive. An employment contract adds stability and continuity to this situation by setting forth terms under which the executive is overseen, evaluated and terminated. Abrupt changes in relationship between an executive and his or her board are far more likely to result in serious disputes or litigation. Thus, the employment agreement is again an asset to the organization in that it lessens the likelihood that the organization will be seriously disrupted by misunderstandings, disputes or even litigation between the organization and the executive.

Concerning my friend’s point that the contract is probably not enforceable against the employee, I agree only in part. Indeed, no court would attempt to force an employee to work for an employer and many circumstances of an executive’s violation of a contract may not lend themselves to enforcement (the cost of enforcement in terms of time and money can be very high). Still, most executives will abide in the agreement unless the situation is a very ugly or negative one. Meanwhile, the contract continues to protect the employer in many other ways and serves as the basis for recovery if legal enforcement of the contract against the executive is deemed necessary.


Long story short, I strongly recommend a written contract exist between a nonprofit and its executive. True, an employment contract benefits the executive, but the advantages and security a nonprofit receives from the contract more than justifies its existence.

Monday, January 4, 2010

Tax Time Coming Up - UBIT Guidelines for 501(c) Organizations

Characterization of association income is sometimes a tricky subject.  Most association executives are well aware of unrelated business income (UBI) principles, but are understandably cautious about characterizing that income.  This post will attempt to refresh your understanding of UBI, give you examples of common income characterizations, and provide guidance on when to call on tax and legal advisors with UBI questions.  You can find detailed information by clicking here for official IRS documentation IRS guidelines on UBIT, revised March 2009.

UBI Basics

Although an organization may be exempt from state and federal income tax, it still may be liable for tax on its unrelated business income (UBIT). Unrelated business income is income from a trade or business, regularly carried on, that is not substantially related to the performance by the organization of its exempt purpose or function except that the organization needs the profits derived from this activity. 

The rationale for taxing UBI is to place for-profit and non-profit entities on equal footing for tax purposes: nonprofits are not allowed the competitive advantage of exemption from tax concerning their programs that are not conducted primarily in furtherance of their exempt purpose.

An exempt organization that has $1,000 or more gross income from an unrelated business must file Form 990-T, and may be required to pay unrelated business income tax (UBIT), at corporate tax rates.  Corporate tax rates are 15% of the first $50,000 of taxable income; 25% of the next $25,000 of taxable income; and 34% of taxable income in excess of $75,000.  Additionally, income in excess of $100,000 is subject to a surtax of 5% until the tax benefit of the lower rate structure is recovered ($11,750 in tax).

An activity is an unrelated business, and subject to UBIT, if it meets all three of the following requirements:
  • It is a trade or business,
  • that is regularly carried on, and
  • that is not substantially related to the furtherance of the exempt purpose of the organization.
The term "trade or business" generally includes any activity carried on for the production of income (that is, the motive is to generate a profit) from selling goods or performing services.   Many non-UBI activities of associations could be considered a trade or business.

Business activities are generally considered "regularly carried on" if they show a frequency and continuity, and are pursued in a manner similar to, comparable commercial activities of nonexempt organizations.  An annual tradeshow or golf tournament is generally not considered regularly carried on; operation of an insurance brokerage program is regularly carried on.

Determination of whether a business activity is "substantially related" to exempt purposes can be difficult.  It requires careful review of the relationship between the activities that generate income and the accomplishment of the organization's exempt purpose. A trade or business is substantially related to exempt purposes when the business activities are carried out primarily to achieve exempt purposes, not simply for the production of income needed to carry out the exempt purpose.  In other words, the activities which generate the income must contribute importantly to the accomplishment of the organization’s exempt purposes to be substantially related.

Characterizing UBI

As noted above, characterizing association income can be tricky.  There is no “approved list” of activities that are related or unrelated.  Each situation must be analyzed based on its own facts.  Some situations are simple, and some are so difficult that they lead to litigation.   The vast majority of situations are not difficult.  The key is to know when to characterize business income yourself, and when to call on an expert.

The following circumstances generally do not constitute an unrelated trade or business:
  • All of the work of the trade or business is performed for the organization without compensation. Some fund-raising activities, such as volunteer operated bake sales, may meet this exception.
  • The trade or business is carried on by an organization described in section 501(c)(3) organization primarily for the convenience of its members, students, patients, officers or employees.  A typical example of this is a cafeteria or coffee shop.
  • The trade or business consists of selling merchandise, substantially all of which the organization received as gifts or contributions. Many thrift shop operations of exempt organizations would meet this exception.
  • Amounts received in exchange for the use of the association’s name or logo (or any valuable intangible right) are royalties.  Many association affinity and/or endorsement programs generate royalties that would fall within this exception.
  • Trade shows and conventions carried on as part of the association’s exempt purpose.
  • Associate member dues revenues, provided the associate member category has a genuine purpose other than producing income.  The key is the motive of the association:  the reasons the association accepts associate members must relate directly to or advance the mission and purposes of the association.  That an association member has a right to participate in association activities (not necessarily voting, but valuable activities) may help make the case that associate members are not admitted solely for purposes of generating revenue.
  • Revenues from the rental or licensing of membership mailing lists.  This does not include an active role in the promotional use of membership lists.  It is acceptable for the association to control who rents the list, collect payment and analyze results of the mailing to determine if the mailing was successful.
  • Annuities received, in most cases.  Consultation with an advisor concerning the taxability of this type of income is recommended.
  • Generally, rents from real property and incidental rents from person property leased with real property, except if the property is debt-financed.  Consultation with an advisor concerning the taxability of this type of income is recommended.
The following circumstances are generally considered unrelated business activities:
  • Revenues received in exchange for advertising in association publications.  Calculation of the UBIT is sometimes exasperatingly complicated.  A qualified accountant should be involved in determining the amount of advertising income that should be regarded as UBI. [Incidentally, the line between advertising and acknowledgements of support can be fine, particularly as it relates to sponsorships.  Some sponsorship benefits, such as discounted booth or magazine advertising space and logo placements on magazines and trade show banners, are likely to translate into more than mere acknowledgements.  Such benefits may be viewed as paid-for advertising, on which the association would owe UBIT.]
  • Income generated from subsidiaries or other “controlled” organizations, in most cases.  Consultation with an advisor concerning the taxability of this type of income is recommended
  • Insurance program revenues, other than royalties.  Consultation with an advisor concerning the taxability of this type of income is recommended.
UBI and Certification Programs

Certification programs can be difficult to characterize as related or unrelated.  Certification programs are frequently organized as public benefit entities (generally exempt pursuant to Section 501(c)(3) of the Internal Revenue Code).  As a public benefit entity, the organization operate exclusively for public benefit purposes.

A certification program intended at improving competence is likely to be viewed as having a substantially related, public benefit purpose.  Conversely, a certification program aimed at enhancing member marketability or the image of the profession is not a public benefit purpose; the genuine exempt purpose of the program is considered merely incidental.  The effect of these rules is that the IRS generally regards public benefit corporation certification programs as unrelated, and therefore subject to UBIT.

UBIT Strategy

Remember, UBI is a good thing.  It is better to have had the income and pay taxes on it, than never to have had the income.  That said, the less the tax, the better.

As a general rule, all sources of association revenue should be reviewed to identify UBI issues.  If the characterization cannot be made readily, careful analysis of the circumstances will be required.  The objective is to characterize the income as unrelated or related business income, and file tax returns accordingly.

Agreements relating to income programs should be written to connect the program to the exempt purposes of the association as closely as possible.  Also, agreements relating to the income program should, if applicable, be separate for non-UBI and UBI components.  For example, an association might have two agreements pertaining to its sponsored insurance program:  One for royalties for use of the association’s name and logo, and another for fees for administrative services the association will perform under the program.  The royalty income should be tax free, and the administrative fees subject to UBIT.

Limits on UBIT

Not surprisingly, there are limits on how much UBI an association (501(c)(6) exempt) can receive with undermining its tax exemption.  An association that is primarily engaged in generating UBI is likely to be viewed as not operating primarily (generally, greater than 50% of resources) for exempt purposes.  In such cases the association may wish to establish a for-profit subsidiary to conduct the unrelated activities.  If your UBI approaches 30 to 40 percent of total revenues, this issue should be taken very seriously.

Analysis of how much UBI a charitable organization (501(c)(3) exempt) can receive is more difficult, because a c-3 organization must be organized exclusively for charitable, educational or similar purposes.  Authoritative guidance on how much UBI a c-3 may generate is lacking, but it most definitely is less than would be acceptable for a c-6 organization.  C-3 organizations with UBI revenue streams should consult with expert advisors.

When assessing whether or not an organization has too much UBI, it is important to distinguish between non-dues revenues and UBI.  Non-dues revenue is frequently “related” business income.  There is no limit on the amount of non-dues revenue an association may make, provided the association operates in a manner consistent with its exempt status.


Characterization of income of an association as either related business income (tax exempt) or unrelated business income (subject to UBIT) is critical.  In some instances the characterization is relatively simple; in others it is appropriate to consult with expert tax and legal advisors.

[This post contains numerous generalizations concerning complicated matters.  Generalizations are helpful for educational purposes, but are not necessarily accurate when applied to specific situations.  As such, the reader is cautioned not to rely on the information set forth in this article as professional advice, or as a reliable characterization of income of any particular enterprise.]